What Are Elasticities & Why Do Economists Use Them?

Before we get to it, here is a tip to get the most learning for your time… Use the list of learning objectives below to help you to identify (1) the key concepts of this lesson and (2) what you should be able to do once you master them.

By the end of this lesson, you should be able to:

Explain how sensitivity affects the magnitude of a response.
Define elasticity.
List the four different elasticities.
Identify what the four different elasticities have in common.

An elasticity is a measure of sensitivity. Not sensitivity to smells, certain foods, or allergens in the air, although it has something in common with all of these things: we can be very sensitive to something, in which case a given change will have a big effect on us, or not sensitive at all, in which that same change will have a small effect on us, if at all.

Sensitive: A Lot, A Little, or Not at All?

Suppose we are talking about smells, like in the pictures above. By the way, did you know that the sense of smell is closely linked to memory, and probably more so than any other sense?

Smells can be a great thing or a bad thing, depending on whether the aroma is good, like a nice perfume, or the aroma is bad, like that of a skunk. Some people actually have no sense of smell at all, a condition called anosmia, so they are unable to smell anything, from fire to a bouquet of roses. Those with hyperosmia, on the other hand, have a heightened sense of smell, so they can get experience quite the discomfort when exposed to strong scents. When exposed to a strong smell, like that of flowers, they will display quite different reactions, or responses, don’t you think?

Suppose we offer a bouquet of fragrant roses to three people, Emily, Ursula, and Inez. We think we are having a lovely gesture towards our friends. Here’s what happens the moment we step into the room and offer the bouquet:

Emily looks at us in horror and says she can not be in the room with the bouquet as it will give her a headache. She thanks us and leaves.
Ursula promptly puts the bouquet in a jar close by, so she can smell it whenever she likes.
Inez looks at the bouquet in disbelief, she expects us to remember she has no sense of smell, so she puts it in a jar and does not look at it again.

Each friend displays a totally different reaction to our gesture. When offered a bouquet of fragrant roses, one leaves the room, another is quite happy, and the other does not care at all. Based on this, who do you think is the most sensitive to smells? What makes you think that? Who do you think is the least sensitive to smells? What makes you think that?

Fill in the blanks.
_____ is the most sensitive to smells because she displays a _____ response by _____.
_____ is the least sensitive to smells because she displays a _____ response by _____.

Most likely, you judged each friend’s sensitivity to smells by looking at their response, how their behavior changes when exposed to an event. A big response, like storming out of the room, is a synonym of a big sensitivity, whereas no response at all, like putting it in a jar and not looking at it, is a synonym of a small sensitivity.

So now you understand that being sensitive to something means showing a big response whereas not being sensitive means going by your business as if nothing happened. Elasticity then helps us to describe this sensitivity with panache: it measures magnitude of the response and quantifies it, allowing us to express subjective terms in a more objective way. It’s hard to argue with a number.

Finally, how would you respond if you were offered a bouquet?

Elasticity in Economics

In economics, an elasticity measures the magnitude of the response of a change in one variable to a change in another variable.

By putting a number in the sensitivity, it saves us from saying the variable responded by “a lot” or by “a little”, which are subjective and, most importantly, not informative.

4 Elasticities

Economists are so nuts about elasticities that they have four of them. Yes, four. Fortunately, they all do similar jobs. And they look at something somewhat similar — see if you can spot it.

Demand-Side Elasticities

Just on the Demand side, there are three elasticities: the Price Elasticity of Demand, the Income Elasticity of Demand, and the Cross-Price Elasticity of… wait for it, Demand. I bet that came as a surprise. Not.

The Price Elasticity of Demand, or simply Elasticity of Demand, is the most popular elasticity. Read the name carefully to notice it includes the words “price” and “Demand.” It should not come as a surprise that it quantifies the sensitivity of the Demand for a good to a change in the price of that good by comparing the percentage change in quantity demanded to the percentage change in the price of the good.

Here is a bit of motivation for the Price Elasticity of Demand…

Fortunately for us, the terminology really helps, and each name contains the variables that it analyzes.

Two other elasticities that also pertain to the Demand side are the Income Elasticity of Demand and the Cross-Price Elasticity of Demand. The Income Elasticity of Demand quantifies the sensitivity of Demand to a change in income by comparing the percentage change in quantity demanded to the percentage change in income. The Cross-Price Elasticity of Demand quantifies the sensitivity of Demand to a change in the price of another good by comparing the percentage change in quantity demanded to the percentage change in the price of another good.

Did you see what all elasticities have in common? Maybe a simple exercise may help.

Fill in the blanks with the Demand-side elasticities.

The _____ compares the percentage change in _____ to the percentage change in the price of the good.
The _____ compares the percentage change in _____ to the percentage change in the price of another good.
The _____ compares the percentage change in _____ to the percentage change in income.

In common, the three Demand elasticities above have the fact that they all quantify the sensitivity of Demand to a change in something, be that the price of the good itself, like in the Price Elasticity of Demand, income, like in the Income Elasticity of Demand, and the price of another good, like in the Cross-Price Elasticity of Demand. Each one compares the percentage change in quantity demanded to the percentage change in a different variable, may it be the price of the good, income, or the price of another good, respectively.

Supply-Side Elasticity

Finally, the Price Elasticity of Supply, or Elasticity of Supply, quantifies the sensitivity of the Supply of a good to a change in the price of that good by comparing the percentage change in quantity supplied to the percentage change in the price of the good.

Now fill in the blanks with the Supply-side elasticity.

The _____ compares the percentage change in _____ to the percentage change in the price of the good.

If you filled in all the blanks above, you noticed that on the second blank you always included the word quantity. All four elasticities thus look at how quantity, be it quantity demanded or quantity supplied, responds to a change in another economic variable.